The efforts of South African banks to comply with the Basel III framework on banking supervision, which is being adopted in a phased-in approach between 2013 and 2019, paves the way for innovative solutions for funding long-term infrastructure projects.
South African infrastructure projects have traditionally relied very heavily on banks for most of their financing but, due to the impact of Basel III, many are going to have to look at a broader range of funding options as banks find it increasingly difficult to finance long-term projects. Instead of banks funding the entire 20-year project, we are likely to evolve to a model where they finance the initial stages of a project. The remaining funding will stem from project bonds or loans sold to institutional investors, such as pension funds and life companies that have an appetite for long-dated assets to match their long-dated liabilities.
The tighter capital requirements of Basel III, along with the new liquidity standards, the liquidity coverage ratio (LCR) and the net stable funding ratio (NSF ratios), means that banks will be required to match the tenure of their funding with the tenure of their lending. Banks have until 2015 to comply with the LCR and until 2018 to meet the NSF ratio.
In other words, if a South African bank wants to fund a 20-year infrastructure project, it will need to structure its balance sheet funding to align with the project tenure to meet the Basel III funding and liquidity requirements. However, South African fund managers, which are a large source of funding for domestic banks, are typically reluctant to provide such long-term funding to banks due to the perceived real rate of return on such investments.
The result is that South African banks are heavily exposed to shorter-term funding of between three and six months as local fund managers are reluctant to provide capital to banks over a timeframe that may involve being repaid over 15 to 20 years. This restricts their ability to invest in other asset classes that may provide better returns over time.
Given that Basel III now requires banks to obtain more longer-dated funding, preferably with a tenure of one year or more, South African banks are finding it difficult to finance longer-term projects at competitive market rates. The premium they charge to invest in such projects means that an alternative funding mix will need to be developed in order to arrive at a lower-cost long-term funding structure.
The implication is that South Africa’s R3.4 trillion infrastructure programme is going to have to look beyond the banking system and government to secure funding for long-term projects. We are most likely going to evolve into a model that is utilised in Europe and the United States, where the project funding structure usually comprises an equity tranche and a short-term debt tranche. The equity tranche is typically funded by the project promoter and the debt piece by a bank in the construction phase, as institutional investors do not like to take construction risk. Once the project is commissioned and proven, the funding is refinanced, with an infrastructure fund taking the equity piece from the promoter. The project bond, often listed, replaces the bank construction bridging finance and is then sold to institutional investors, such as pension funds and life companies, with an appetite for long-dated paper delivering a stable return.
The life insurance industry is an untapped source of potential funding for long-term infrastructure projects. However, alternative solutions to long-term infrastructure funding can be found when one partners with innovative advisors.
Deloitte has already structured a listed infrastructure project bond, a first for South Africa, that was issued in April this year via a special purpose vehicle created by Soitec Solar GmbH (60%), its empowerment partner Pele Green Energy (35%) and the Touwsrivier Community Trust (5%) to fund a 44MW Concentrated Photo Voltaic Solar renewable energy power plant in the Western Cape. The bond was assigned a Moody’s Baa2.za South African national scale rating for ZAR1.0 billion of notes issued by CPV Power Plant No.1 Bond SPV (Bond) Limited. The notes have a maturity of 16 years from the date of issue in an amortising repayment profile and pays a fixed coupon of 11%.
In conclusion, the challenge that faces advisors and lenders is to start developing new products to address the changes in funding environment as a result of Basel III. Advisors will also need to work closely with their clients to structure deals and raise funds differently than they have in the past. This change will also involve spending time with the life companies to ensure that their concerns and questions are addressed as they move into infrastructure funding space.